TESTIMONY OF
ARTHUR LEVITT, CHAIRMAN
U.S. SECURITIES AND EXCHANGE COMMISSION
CONCERNING THE "FINANCIAL SERVICES
COMPETITIVENESS ACT OF 1995" AND RELATED ISSUES
BEFORE THE COMMITTEE ON BANKING AND FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
MARCH 15, 1995
Chairman Leach and Members of the Committee:
I appreciate this opportunity to testify on behalf of the
Securities and Exchange Commission regarding H.R. 18, the
"Financial Services Competitiveness Act of 1995," introduced
earlier this year by Chairman Leach.-[1]- I would like to thank
you, Mr. Chairman, for holding these hearings and initiating the
present dialogue on Glass-Steagall reform and financial services
modernization.
The Commission supports the principal purpose of H.R. 18,
which is to permit banks to participate more fully in the
securities business through affiliated companies. Glass-Steagall
reform would provide banks with greater flexibility and new
avenues for innovation. By bringing new bank competition to the
market for securities services and products, Glass-Steagall
reform could also benefit consumers and the financial markets as
a whole. The Commission would welcome these developments.
Much of the debate on Glass-Steagall reform and financial
services modernization to date has focused on these bank-related
issues. This is understandable. The special role of banks in
the U.S. economy, the important safety and soundness issues
linked to the solvency of the federal deposit insurance safety
net, and the competitive benefits Glass-Steagall reform will
bring to the banking industry, are all important issues that
deserve serious consideration.
As Congress considers how, and to what extent, to permit
affiliations between the banking and securities industry, it is
important also to remember that Congress' actions in this area
will likely have a profound effect on investors and the
securities markets generally, as well as banks. As the debate on
Glass-Steagall reform moves forward, the Commission urges the
Committee to keep in mind two important principles:
First, the investors' perspective must be maintained.
Investors benefit from a wide array of financial products and
providers. Investors benefit more when they can be assured of
-------- FOOTNOTES --------
-[1]- H.R. 18 was revised and reintroduced as H.R. 1062 on
February 27, 1995. We refer to the revised bill as
H.R. 18 for the purpose of this testimony.
-------------------- BEGINNING OF PAGE #2 -------------------
the integrity of markets and when they can be assured they will
receive a high level of investor protection. The Commission
therefore urges Congress to make investor protection as much of a
priority as bank safety and soundness.
Second, the vitality of our capital markets must be
preserved. The U.S. capital markets are the deepest, most
liquid, and strongest in the world. In 1994 alone these markets
raised $1 trillion in capital for companies, to support new
industries and create new jobs. This capital was raised directly
from private investors, without the benefit of federal deposit
insurance. As Congress weighs expanding bank securities powers,
it must be careful not to impose bank-style "safety and
soundness" requirements or constraints on the securities markets
that could impair their continued success.
The Commission is pleased that H.R. 18 takes steps to
address these issues. Specifically, the bill contains provisions
that would enhance investor protection by promoting functional
regulation of bank securities activities. The Commission
strongly supports the principle of functional regulation; we have
long maintained that Glass-Steagall reform must be accompanied by
reforms to bring bank securities activities within the securities
regulatory scheme. Such an approach would ensure that the
securities and banking activities of all market participants --
regardless of the structure in which they are conducted -- would
be subject to a single set of standards, consistently applied by
one expert regulator.
In addition, H.R. 18 contains important provisions that
would facilitate regulatory coordination and information-sharing.
These provisions recognize and build on the concept of functional
regulation, and are intended to promote efficient regulation that
does not unduly burden the operation of our capital markets.
The Commission strongly supports the thrust of these
provisions. However, we believe that additional attention to
these areas is warranted. In particular, the Commission has
concerns regarding the numerous exceptions in H.R. 18's
functional regulation provisions, which would allow banks to
engage in significant securities activities outside the
securities regulatory scheme. Likewise, more can be done to
clarify and strengthen the provisions aimed at achieving what
FDIC Chairman Ricki Tigert Helfer described as "seamless"
regulatory co-ordination.-[2]-
The Commission fully appreciates the difficulty of the
Committee's task. In reforming Glass-Steagall, the goals of
safeguarding bank safety and soundness and maintaining a fair and
competitive securities market must be harmonized. The Commission
is convinced that adoption of a strong system of functional
-------- FOOTNOTES --------
-[2]- Testimony of Ricki Tigert Helfer, Chairman, Federal
Deposit Insurance Corporation ("FDIC"), on the
"Financial Services Competitiveness Act of 1995" and
Related Issues Before the House Committee on Banking
and Financial Services, Feb. 28, 1995, at 11.
-------------------- BEGINNING OF PAGE #3 -------------------
regulation will make it easier to strike the appropriate balance.
Finally, the Commission recognizes that Glass-Steagall
reform raises many other complex, related questions, such as how
to provide a "two-way street" for securities firms that wish to
acquire banks. The Commission believes that in order to preserve
the vitality and fairness of our markets, financial reform must
provide equal opportunities for all market participants. The
Commission is pleased to assist the Committee as it considers
this and other important issues, and looks forward to working
with the Committee toward our shared goals.
The remainder of this statement provides background
information on the existing regulatory structure for bank
securities activities and discusses functional regulation, the
"two-way street," and related issues. More detailed comments on
the securities-related provisions contained in H.R. 18 are set
forth in the appendix to this testimony.
I. The Existing Regulatory Structure and the Need for
Regulatory Reform
A. Background and recent market developments
Before enactment of the Glass-Steagall Act, some sixty years
ago, U.S. banks were significant participants in the nation's
capital markets. Indeed, by 1930, bank affiliates were
sponsoring over 50 percent of all new securities issues, and 41
percent of all commercial bank assets were invested in securities
or securities-related loans.-[3]-
Bank involvement in the securities markets came under close
scrutiny after the 1929 market crash. The Pecora hearings of
1933, which focused on the causes of the crash and the subsequent
banking crisis, uncovered a wide range of abusive practices on
the part of banks and bank affiliates. These included a variety
of conflicts of interest;-[4]- the underwriting of unsound
securities in order to pay off bad bank loans; and "pool
operations" to support the price of bank stocks.
Revelations about these and other abuses reinforced concerns
about the role that banks had played in the speculative fever of
-------- FOOTNOTES --------
-[3]- See Susan E. Kennedy, The Banking Crisis of 1933 212
(1973); Donald Langevoort, Statutory Obsolescence and
the Judicial Process: The Revisionist Role of the
Courts in Federal Banking Regulation, 85 Mich. L. Rev.
672, 694 (1987). Banks and bank affiliates by 1930
also claimed a 61 percent market share of new bond
issue participations. See Edwin Perkins, The Divorce
of Commercial and Investment Banking, 88 Banking L. J.
483, 495, 527 (1971).
-[4]- Congress was concerned, for example, about the use of
bank loans to support bank affiliates and affiliate-
underwritten securities, and about bank incentives (in
giving investment advice) to promote affiliate-
underwritten securities.
-------------------- BEGINNING OF PAGE #4 -------------------
the 1920s. The hearing record also compounded fears that the
securities activities of bank affiliates threatened bank safety
and soundness. Ultimately, strong public reaction to the
hearings prompted the enactment of the Glass-Steagall Act and the
separation of commercial from investment banking.-[5]- At the
same time, banks were excluded from the regulatory scheme enacted
for securities brokers and dealers, based in large part on the
assumption that the Glass-Steagall Act barred banks from engaging
in most securities activities.-[6]-
Much has changed in the six decades that have passed since
the enactment of the Glass-Steagall Act. Economic expansion, new
technologies, and innovative financial products have resulted in
the striking growth of the U.S. capital markets. The $1 trillion
raised in the U.S. capital markets in 1994 represents more than a
1500-fold increase over the $641 million raised in 1934.
Regulatory changes, meanwhile, have allowed banks to play an
ever-larger part in those capital markets. Over the last two
decades, through expansive banking agency interpretations, banks
have gained entry into a wide range of securities activities that
were once thought to be foreclosed by the Glass-Steagall
Act.-[7]- To offer just a few examples:
-------- FOOTNOTES --------
-[5]- There is a broad spectrum of views on the degree to
which the Glass-Steagall Act actually responded to the
causes of the banking crash. See, e.g., ICI v. Camp,
401 U.S. 617 (1971) (Act was intended to protect bank
safety and soundness by preventing abuses of securities
affiliates); Langevoort, supra note 3 (Act reflects
then-orthodox banking theory that banks should
concentrate on commercial lending, combined with a need
to respond to the public outcry that followed the
Pecora hearings); William Isaac and Melanie Fein,
Facing the Future -- Life Without Glass-Steagall, 37
Cath. U. L. Rev. 281 (1988) (no link was ever shown
between securities activities and collapse of banking
system; Act responded to public outcry rather than hard
evidence).
-[6]- See Stock Exchange Regulation: Hearings on H.R. 7852
and H.R. 8720 Before the House Comm. on Interstate and
Foreign Commerce, 73d Cong., 2d Sess. 86 (Feb. 16,
1934) (statement of Thomas G. Corcoran, an
administration spokesman and a principal drafter of the
Securities Exchange Act of 1934). Later, the
Investment Advisers Act of 1940 also excluded banks and
bank holding companies from regulation as investment
advisers.
-[7]- At the same time, securities firms have entered into
some aspects of the banking business. For example,
recent reports state that Goldman, Sachs & Co. will
join with four commercial banks in underwriting a $1.5
billion bank loan in connection with the acquisition of
Santa Fe Pacific Corp. by Burlington Northern Inc. See
S. Lipin, Goldman Sachs, Taking Unusual Role, Joins
Bank Loan for Santa Fe Takeover, Wall St. J., Feb. 3,
1995, at A4.
-------------------- BEGINNING OF PAGE #5 -------------------
* in 1994, 119 banks provided investment advice or other
services to over $312 billion in mutual fund assets
(representing approximately 15% of total mutual fund
assets);-[8]-
* in 1994, over 1800 banking firms sold mutual funds to their
customers;-[9]-
* as of January 1995, the Federal Reserve had authorized 36
bank holding companies to operate so-called "Section 20"
underwriting affiliates;-[10]-
* in the third quarter of 1994, the assets of Section 20
affiliates accounted for 16.6% of the assets of all broker-
dealers doing a public business.-[11]-
The statutory framework for bank securities activities has
not evolved to keep pace with the dramatic changes that have
taken place in U.S. financial markets in recent years.-[12]- On
the one hand, the Glass-Steagall Act continues to limit the scope
of permissible bank activities. On the other hand, the outdated
bank exclusions still contained in the federal securities laws
allow banks to conduct a wide range of securities activities
outside the regulatory scheme established for all other broker-
dealers and investment advisers.
Clearly, the time has come to modernize the existing
regulatory structure for banks. At the same time, it must be
recognized that entry into the securities business involves its
-------- FOOTNOTES --------
-[8]- See Lipper Bank-Related Fund Analysis (4th Quarter
1994). Commission records indicate that banks advise
approximately 35% of all open-end fund portfolios
(total: 4,899) or approximately 8% of all investment
company portfolios (total, including closed-end funds
and unit investment trusts: 27,764).
-[9]- See Michelle Clark, Call Reports Show Surprisingly Few
Banks Selling Funds, American Banker, Aug. 25, 1994, at
12.
-[10]- Sixteen of these affiliates had received approval to
underwrite both corporate debt and equity issues.
-[11]- Section 20 affiliates also accounted for 7.7% of the
total capital and equity capital, for 12.1% of total
revenues, and for 15.6% of total proprietary trading.
-[12]- Certain statutory changes have, however, addressed some
of the problems identified in the Pecora hearings. For
example, Federal Reserve Act sections 23A and 23B limit
and set standards for transactions between banks and
their affiliates. Moreover, the federal securities
laws address the problem of inadequate disclosure,
prohibit insider abuses and other forms of securities
fraud, and provide for federal market oversight.
-------------------- BEGINNING OF PAGE #6 -------------------
own risks.-[13]- Indeed, risk-taking is fundamental to the
securities business.-[14]- Congress, therefore, in considering
Glass-Steagall reform, will have to strike a careful balance
between protecting bank safety and soundness and permitting the
risk-taking that is central to capital markets activities.
Banking regulation has traditionally limited bank risk-taking, in
the interests of bank safety and soundness. But securities
firms, and the securities markets generally, specialize in
entrepreneurial and risk-taking activities.-[15]- Sometimes they
misjudge: securities firms may have "bad years" (as in 1994) and
may even fail. Nonetheless, it is through taking on market risks
that securities firms are able to serve as a powerful engine for
U.S. capital formation.
B. Current regulation of bank securities activities
Before turning to a discussion of how the existing
regulatory structure should be reformed, it is important to
review the current framework for bank securities activities and
some of the more significant disparities that exist with respect
to bank broker-dealer and investment adviser activities.
-------- FOOTNOTES --------
-[13]- Lending and other banking activities, of course, also
involve risk. See Testimony of FDIC Chairman Tigert,
supra note 2, at 3-4.
-[14]- Markets are by nature volatile; they go down as well as
up. Thus, while 1993 was generally a profitable year
for securities firms, 1994 was labelled "Wall Street's
worst business environment in years." Salomon Inc, CS
First Boston Co., Goldman Sachs, and J.P. Morgan & Co.
(for example) suffered lower earnings or losses and
subsequently announced layoffs and other cost-cutting
measures. See Red Braces, Pink Slips, The Economist,
Feb. 18, 1995, at 73. Only last month J.P. Morgan (the
first banking firm approved to engage in corporate debt
and equities underwriting through a Section 20
affiliate) lost its long-standing triple-A rating from
Moody's Investors Service, Inc., due in large part to
concerns regarding J.P. Morgan's move away from
commercial banking and into investment banking. See S.
Kleege, Moody's Lowers Rating for Morgan, Citing Focus
on Investment Banking, Am. Banker, Feb. 15, 1995, at
24.
-[15]- For this reason, securities regulation does not seek
completely to insulate securities firms from the risks
they incur in their business activities. Instead, the
regulatory framework seeks to protect investors and
maintain fair and orderly markets by imposing
financial responsibility, training and competency,
supervision, disclosure, antifraud and other
requirements on securities firms. Within these
parameters, risk-taking is largely left to market
control, not to governmental management.
-------------------- BEGINNING OF PAGE #7 -------------------
Today, banks engage directly-[16]- in a wide range of
broker-dealer and investment advisory activities that are
comparable to, and competitive with, the services of registered
securities firms and investment advisers. They generally do so,
however, outside the regulatory framework established under the
federal securities laws.-[17]-
Banking regulation -- which does apply to bank securities
activities -- has not traditionally focused on investor
protection and the maintenance of fair and orderly markets. The
banking agencies are charged with protecting the viability of
banking institutions, as well as the solvency of the federal
deposit insurance system. In contrast, the Commission has as its
focus disclosure, market discipline, and enforcement, with an
overall mandate to protect investors and maintain fair and
orderly securities markets. These different philosophical
approaches affect the ways in which regulation and enforcement
are undertaken.-[18]-
Bank broker-dealer activities.
Banks that engage directly in securities activities are
excluded from the definitions of "broker" and "dealer" in the
Exchange Act and are therefore exempt from broker-dealer
regulation under the federal securities laws. Their activities
are subject only to federal banking law and the antifraud
provisions of the federal securities laws. Federal banking laws
-------- FOOTNOTES --------
-[16]- Banks also may choose to engage in securities
activities through a number of indirect routes. For
example, a bank may conduct its sales or investment
advisory activities through subsidiaries or affiliates
registered with the Commission. This section of the
Commission's testimony, however, focuses on the direct
securities activities of banks. Such activities --
though subject to the antifraud provisions of the
federal securities laws -- take place outside the
federal regulatory scheme for securities activities.
-[17]- The unique treatment afforded bank securities
activities stands in contrast to the regulatory schemes
for bank transfer agents and bank municipal and
government securities activities, which are regulated
under the federal securities laws.
-[18]- For a discussion of the differences in philosophy and
specific requirements between banking and securities
regulation, see Testimony of Chairman Arthur Levitt
Before the Subcommittee on Telecommunications and
Finance of the House Energy and Commerce Committee
Concerning H.R. 3447 and Related Functional Regulation
Issues (April 14, 1994) at 2. For a detailed, side-
by-side comparison of banking and securities laws and
regulations, see Proposed Mellon-Dreyfus Merger:
Hearings Before the Subcomm. on Oversight and
Investigations of the House Comm. on Energy and
Commerce, 103d Cong., 2d Sess. 906-72 (1994).
-------------------- BEGINNING OF PAGE #8 -------------------
and regulations, however, do not specifically address important
aspects of bank brokerage activities.-[19]- For example:
* Banking regulations do not require banks to register or
provide information regarding their securities activities,
nor do they impose special financial responsibility
requirements as a condition of engaging in direct securities
activities.
* Banking regulations do not establish specific qualification
and continuing education requirements for bank securities
salespersons.
* Federal banking law does not provide for the statutory
disqualification of bank securities salespersons with
disciplinary histories.
* The federal banking statutes and regulations do not
comprehensively address sales practice issues, nor do they
impose an explicit duty to supervise bank securities sales
personnel.
Finally, bank securities customers have no formal avenue of
redress for complaints, and the federal banking laws do not
generally contain private rights of action for
investors.-[20]-
Over the last two years, the federal banking agencies have
issued guidelines and a subsequent Interagency Statement-[21]-
designed to supplement their securities regulatory programs.
While these guidelines represent an important forward step, they
do not create a comprehensive securities regulatory scheme for
banks. As "guidelines" rather than regulations, they are
advisory rather than legally binding, and may not be legally
enforceable by the bank regulators or by bank customers.
Furthermore, the guidelines do not establish precise standards of
conduct; banks are given wide latitude to establish procedures
and policies to implement them.
The guidelines, moreover, raise potential problems of
regulatory overlap insofar as they apply to registered broker-
-------- FOOTNOTES --------
-[19]- The federal banking laws do, however, contain limited
recordkeeping and confirmation requirements relating to
bank securities transactions. See, e.g., 12 C.F.R.
12.1-12.7, 12 C.F.R. 344.1-344.7, and 12 C.F.R.
208.8(k).
-[20]- See, e.g., In re Fidelity Bank Trust Fee Litigation,
839 F. Supp. 318 (E.D. Pa. 1993); In re Corestates
Trust Fee Litigation, 837 F. Supp. 104 (E.D. Pa. 1993).
-[21]- See Board of Governors of the Federal Reserve System
("Federal Reserve Board"), FDIC, OCC, and Office of
Thrift Supervision, "Interagency Statement on Retail
Sales of Nondeposit Investment Products" (Feb. 15,
1994) (the "Interagency Statement").
-------------------- BEGINNING OF PAGE #9 -------------------
dealers that are affiliated or have contracts with banks for the
sale of securities.-[22]- Since broker-dealers are already
subject to comprehensive Commission and self-regulatory
organization ("SRO") regulation under the federal securities
laws, imposing an additional layer of banking regulator oversight
and examinations is unnecessary.
Bank investment adviser activities.
A separate set of problems exists with respect to the
regulation of banks that advise registered investment companies
("funds"). Banks are excluded from Commission oversight under
the Advisers Act (although bank advisory relationships with funds
are subject to the Investment Company Act of 1940). Because bank
advisers are not required to register with the Commission as
investment advisers, Commission examiners may not have access to
all the books and records normally available when the adviser is
registered.-[23]- In addition, banks are not subject to a number
of substantive requirements applicable to other investment
advisers, including regulation of performance fees, procedures to
prevent misuse of non-public information, and the Advisers Act
anti-fraud provisions.
In other respects, bank-advised funds (like bank-affiliated
broker-dealers) face the problem of overlapping regulation. Some
of the banking agencies have recently indicated that they may
expand their role to include oversight of funds advised by
banks.-[24]- This move is likely to create new problems in the
form of duplicative and potentially conflicting regulation, as
bank-advised funds become subject to multiple regulators. As one
commentator has noted, "we are heading toward a world of five
federal mutual fund regulators -- the SEC and the four federal
banking agencies."-[25]-
II. The Case for Functional Regulation
The existing regulatory framework for bank securities
activities -- containing both gaps and redundancies -- plainly
needs to be restructured. Investor protection must be made a
priority, and the regulatory system must be made more efficient
and more rational. The adoption of functional regulation, in our
view, is necessary to achieve the following important objectives:
-------- FOOTNOTES --------
-[22]- The OCC, for example, has recently begun to examine
registered broker-dealers that sell securities in
association with national banks.
-[23]- Commission records indicate that approximately 61% of
bank-affiliated investment companies are managed by
investment advisers not subject to full Commission
oversight.
-[24]- See, e.g., S. Prakash, "Comptroller Drafts Guidelines
for Mutual Fund Activities," American Banker, July 1,
1994, at 12.
-[25]- M. Fink, "SEC Needs a Strong Hand in Regulating Funds,"
American Banker, March 31, 1994, at 13.
-------------------- BEGINNING OF PAGE #10 -------------------
Investor protection.
Functional regulation of bank securities activities would
further investor protection by subjecting all securities
activities to a single set of standards, consistently applied by
one expert regulator -- in marked contrast to the fragmented
system currently in place. Banks and broker-dealers alike would
be subject to the same requirements with respect to training,
supervision, sales practices, financial responsibility, and other
important matters. Banks that advise investment companies, like
all other registered investment advisers, would be fully subject
to oversight and other requirements designed to guard against
conflicts of interest. The Commission strongly believes that
Congress should make these changes to close existing gaps in
investor protection, whether or not broader Glass-Steagall reform
is adopted.
Elimination of duplicative regulation.
Under existing law, bank-affiliated securities firms and
investment companies must comply with overlapping and potentially
inconsistent regulatory requirements. This duplication confuses
the industry, imposes unnecessary costs, impairs industry
competitiveness, and wastes scarce government resources.
Replacement of the existing regulatory scheme with a system of
functional regulation should relieve financial services providers
(and the markets as a whole) from many of the burdens of
duplicative regulation. Of course, with financial services
reform and the expansion of bank securities activities, there
will be an ever-greater need for cooperation among
regulators.-[26]-
III. Two-Way Street and Other Issues
In addition to the issue of functional regulation, Glass-
Steagall reform must address the need to provide for a meaningful
"two-way street," whether to retain some form of consolidated
regulation at the holding company level, and whether to relax the
strict separation of banking and commerce. These are admittedly
difficult issues. The Commission would like to take this
opportunity to add its views to the current debate on this
subject, as well as on related issues involving the structure of
bank affiliations with securities firms.
Subsidiaries vs. affiliates.
-------- FOOTNOTES --------
-[26]- The Commission and its banking agency counterparts have
already taken a number of steps toward improved
regulatory coordination. For instance, Commission and
OCC staff have held discussions on the subjects of (1)
joint inspections of banks and their affiliated mutual
funds, and (2) coordination of enforcement actions.
The Commission is optimistic that this and similar
initiatives will result in better working
relationships. However, these steps will not correct
the underlying flaws in the existing regulatory
structure.
-------------------- BEGINNING OF PAGE #11 -------------------
A threshold matter that is the subject of current debate is
how bank affiliations with securities firms should be structured.
Some have argued that banks should be free to choose between a
subsidiary and a bank holding company affiliate structure.
Others believe that banks, and ultimately the bank insurance
fund, would be better protected if their securities activities
were undertaken in bank holding company affiliates rather than
bank subsidiaries. From a functional regulation perspective, use
of either structure is preferable to directly conducting
securities activities in a bank.
The Commission does, however, prefer the affiliate
structure.-[27]- In our view, it offers a greater separation and
creates sharper distinctions between the bank and any related
securities firm.-[28]- A clear separation between banking and
securities functions guards against confusion, and makes it
easier to build and enforce strong firewalls. Use of affiliates
rather than subsidiaries also serves to limit the potential for
conflicts of interest, such as abusive affiliate
transactions.-[29]- Finally, the Commission generally has had a
positive experience regulating Section 20 broker-dealer
affiliates in the context of a larger holding company structure.
"Two-way street."
Nevertheless, as a general matter, the Commission believes
that for financial modernization reform to be truly effective, it
must allow for vigorous competition between all market
participants. A meaningful "two-way" street must provide equal
-------- FOOTNOTES --------
-[27]- In this regard, Commissioner Wallman believes that the
Commission should have no preference as to whether the
appropriate structure should be a subsidiary,
affiliate, or some other structure. Federal regulatory
agencies should apply the same set of rules to the same
activity engaged in by any entity regardless of its
particular form.
Thus, in his view, if Congress 1) limited overlapping
regulation by the banking and securities regulators and 2)
ensured through a system of strong functional regulation
that the Commission had appropriate authority to regulate
the securities activities engaged in by banks and their
related entities, the form of entity -- provided it was
separate from the bank -- should be irrelevant to the
Commission.
-[28]- See Commission Testimony Concerning S. 543 and S. 713
Before the Senate Committee on Banking, Housing and
Urban Affairs, May 7, 1991, at 22.
-[29]- For example, at present, transactions between a bank
and its affiliates are subject to restrictions
contained in Sections 23A and 23B of the Federal
Reserve Act; transactions between a bank and its
subsidiaries, however, are not governed by those
restrictions.
-------------------- BEGINNING OF PAGE #12 -------------------
opportunities for market participation to banks and securities
firms alike. Competition, moreover, should occur on the basis of
market performance, not differential regulation.
Within the context of the existing regulatory structure,
repeal of the Glass-Steagall Act would allow banking
organizations to acquire securities firms, but would not
necessarily enable securities firms to acquire banks. A
securities firm that sought to acquire even a small bank would
have to submit to comprehensive regulation by the Federal Reserve
as a holding company. Accordingly, those securities firms that
could acquire banks (i.e., those unaffiliated with commercial
entities) would have to accept a radical change in their
regulatory supervision in order to do so. At a minimum, this
would result in significant new regulatory costs.
In expanding bank securities powers, Congress therefore
needs to decide how to give securities firms a meaningful
opportunity to enter into the banking business. This requires a
more focused approach to bank safety and soundness than bringing
all affiliates within the existing framework of consolidated
bank-style regulation.
Consolidated "umbrella" regulation.
The term "umbrella" regulation refers to the type of
consolidated holding company regulation that currently exists
under the Bank Holding Company Act. Among other things, that
model requires regulatory approvals before affiliates may enter a
new line of business, as well as comprehensive supervision of the
holding company and all of its affiliates.
The Commission recognizes that bank affiliations with
securities firms may raise bank safety and soundness issues (and,
ultimately, issues related to protection of the deposit insurance
fund). However, it would be misguided to seek to control these
risks by imposing an overlay of bank-type "safety and soundness"
regulation on nonbank affiliates -- as consolidated bank holding
company regulation currently does. In particular, this approach
is not well-suited for companies that seek to compete vigorously
in new lines of business and fast-moving markets.
In lieu of consolidated holding company regulation, the
Commission would prefer an approach based on strong functional
regulation, effective firewalls, and enhanced regulatory
coordination.
Under this approach, each entity in the holding company
complex would be separately regulated by its expert regulator in
accordance with the principle of functional regulation. The
federal banking regulators (consistent with their special
expertise) would be charged with containing any potential risks
to bank safety and soundness that arise as a result of bank
affiliations with other entities. The Commission and the SROs,
consistent with our statutory mandate and particular expertise,
would enforce investor protection and provide market oversight.
In this manner, duplicative and potentially inconsistent
regulation could be avoided.
-------------------- BEGINNING OF PAGE #13 -------------------
In order to address issues of systemic risk, the functional
regulator should be able to receive information concerning the
activities and exposures of affiliates. This would enable the
functional regulator to monitor the risks to which the regulated
entity is exposed.-[30]- Thus, a bank regulator would have
access to "risk-assessment" information about a securities
affiliate or an information technology affiliate.-[31]-
Firewalls.
The Commission believes that Congress' efforts
to protect bank safety and soundness should pay particular
attention to the creation of appropriate "firewalls" designed to
insulate banks from the risk of their securities affiliates.
Although opinions differ regarding the details of the specific
firewalls, and whether they should be statutory or discretionary
in nature, the Commission believes that most of the parties to
the Glass-Steagall debate acknowledge the importance of
"firewalls" to protect the banking system and the solvency of the
federal deposit insurance system in the context of Glass-Steagall
repeal. To the extent that such firewalls are predicated on bank
safety and soundness concerns, the Commission generally defers to
Congress and the banking regulators.
Firewalls addressing conflicts of interest and other matters
are also important and should be imposed and enforced by
-------- FOOTNOTES --------
-[30]- A model for such a system already exists in the federal
securities laws. Pursuant to the Market Reform Act of
1990, the Commission adopted rules establishing a risk
assessment program that requires broker-dealers to file
quarterly reports on their affiliates within a holding
company group whose business activities are reasonably
likely to have a material impact on the financial and
operational condition of the broker-dealer. Under the
Commission's risk assessment rules, the Commission
receives essentially the same information that an
affiliated bank holding company of a registered broker-
dealer is required to file with the Federal Reserve
Board. We view the information gathered under the risk
assessment program as a significant complement to the
Commission's existing broker-dealer authority.
-[31]- Another approach that merits consideration would build
on the concept of a "broker-dealer holding company."
Under this approach, the Commission would serve as the
holding company regulator for firms whose aggregate
revenues come primarily from the activities of
securities subsidiaries -- even if those firms also
control banks. The Commission's regulatory focus would
be different from that of the Federal Reserve: the
Commission would regulate the broker-dealer holding
company according to a risk-assessment approach based
on the securities regulatory scheme. A more detailed
discussion of this model is set forth in Commission
testimony Concerning Financial Services Modernization
Before the Senate Committee on Banking, Housing and
Urban Affairs, July 19, 1990.
-------------------- BEGINNING OF PAGE #14 -------------------
securities, as well as banking, regulators.-[32]- For example,
firewalls aimed at protecting broker-dealer capital would help
ensure that bank-affiliated broker-dealers can meet their
financial responsibility to customers. Other firewalls could
protect investors against underwriting abuses, such as the use of
underwriting proceeds to pay off bank loans. Conflicts of
interest between banks and the investment companies they advise
deserve particular mention. The Investment Company Act and the
Advisers Act address conflicts that can arise when brokerage
firms or their affiliates conduct investment company activities;
but because the current role of banks in the investment company
business was not contemplated when those Acts were adopted, new
provisions are needed to address the conflicts that can arise
between banks and affiliated investment companies.
The Commission is aware of the current debate regarding
firewalls, and their potential effects on "synergies" between
banks and their affiliates. Without addressing this issue
directly, we would simply note that the firewalls contained in
the Federal Reserve's Section 20 orders do not appear to have
kept Section 20 securities affiliates from competing successfully
in the marketplace for securities services.-[33]-
Commerce and banking.
The issue of commerce and banking directly affects the
viability of any "two-way street" proposal. Broker-dealers often
are affiliated with insurance companies, and they may also hold
equity investments in commercial firms as a result of merchant
banking activities. These firms would be unable to take
advantage of any "two-way street" if divestiture of such
investments is required.-[34]-
The Commission appreciates that this is a difficult issue
from the banking perspective. Viewed from the securities
perspective, however, the Commission has no objections to
allowing commercial entities to engage in the securities
business. The Commission has had considerable experience
recently with the involvement of commercial entities in the
securities business, and it has not been problematic for us. The
Commission's ability to oversee the registered broker-dealers
involved was not impaired and, from time to time, the commercial
-------- FOOTNOTES --------
-[32]- In addition, we believe Congress should give
consideration to maintaining existing prohibitions on
inappropriate tying arrangements.
-[33]- See figures cited supra at 6 and fn. 11.
-[34]- One possible approach to this problem would be to alter
(rather than remove completely) the separation between
commerce and banking, so as to allow combinations of
banking, insurance, and other financial activities.
Under such an approach, it would also be appropriate to
provide for regulatory coordination (along the lines
discussed above) among banking, securities, and
insurance regulators.
-------------------- BEGINNING OF PAGE #15 -------------------
parents provided a ready source of capital to their affiliated
broker-dealers.-[35]-
IV. H.R. 18
H.R. 18 represents a significant contribution to the debate
on Glass-Steagall reform and efforts to modernize our financial
services regulatory structure. H.R. 18 would amend the Glass-
Steagall Act to allow affiliations between banks and securities
firms, through a bank holding company structure and subject to
"firewalls" intended to protect bank safety and soundness. These
affiliated securities firms would have to be separately
incorporated and capitalized. The principle of functional
regulation would apply to these affiliates: they would be
registered with, and regulated by, the Commission just like any
other registered broker-dealer.-[36]-
H.R. 18 would make many other useful changes in the
regulatory framework for bank securities activities. It would
further the principle of functional regulation by repealing the
blanket exclusion of banks from the definitions of "broker,"
"dealer," and "investment adviser" under the federal securities
laws. It would amend various provisions of the Investment
Company Act to take account of growing bank involvement in the
fund business. The bill would also amend the Exchange Act to
eliminate outdated restrictions on broker-dealer borrowing.
Finally, H.R. 18 contains "two-way street" provisions designed to
allow securities firms to acquire banks, as well as provisions
permitting banks to acquire securities firms.
The Commission supports many of the provisions contained in
H.R. 18. We do, however, have three broad concerns about the
bill. First, we believe investor protection may be undermined by
the bill's provisions granting banks extensive exemptions from
broker-dealer regulation. Second, we believe that more can and
should be done to eliminate regulatory overlap (and potential
regulatory conflict) in the oversight and examination of bank-
affiliated securities activities. Third, we believe greater
attention must be given to creating a regulatory structure that
will permit the establishment of a meaningful "two-way street."
A. Bank broker-dealer activities
H.R. 18 would move toward functional regulation of
securities activities by requiring that certain bank securities
-------- FOOTNOTES --------
-[35]- For example, prior to its recent sale to Paine Webber,
Kidder Peabody, a former registered broker-dealer, was
controlled by General Electric. General Electric was
instrumental in infusing capital at critical points.
Similarly, Prudential Insurance Company of America was
an additional source of funding for its securities
affiliate, Prudential Securities, Inc.
-[36]- H.R. 18 thus essentially ratifies the approach the
Federal Reserve has followed since 1987 in approving
limited underwriting activities for "Section 20"
affiliates of bank holding companies.
-------------------- BEGINNING OF PAGE #16 -------------------
activities be conducted in a broker-dealer separate from the
bank, and by partially removing the exclusion of banks from the
definitions of broker and dealer contained in the federal
securities laws. This bank exclusion, as explained above, is a
historical vestige from an era when banks were largely precluded
from the securities business.
The Commission strongly supports removal of the bank
exclusion from the broker and dealer definitions. Removal of
this exclusion would create a "level playing field" for all
market participants, and would ensure that the securities
regulatory scheme is consistently applied to all securities
transactions, irrespective of how an entity is chartered. The
Commission, however, has both general and specific concerns about
the thirteen new exemptions that H.R. 18 would create for bank
brokerage activities.-[37]-
While the Commission does not necessarily object to the
specific aims of some of H.R. 18's exemptions,-[38]- the
inclusion of the numerous exemptions serves to undermine the
principle of functional regulation that H.R. 18 otherwise seeks
to promote. These exemptions would continue to split the
regulation of functionally equivalent brokerage and dealer
activities between the Commission and the bank regulators, and
-------- FOOTNOTES --------
-[37]- The bill's thirteen limited exemptions from the
definition of "broker" and four limited exemptions from
the definition of "dealer" would permit banks to engage
in many securities-related activities without being
subject to securities regulation. Exemptions from the
definition of "broker" are provided for: (i) banks
that engage in brokerage activities in connection with
"networking arrangements," (ii) certain trust
activities, (iii) transactions in exempted and similar
securities, including government securities, (iv)
transactions in municipal securities, (v) transactions
in connection with employee benefit plans, (vi) "sweep"
transactions, (vii) affiliate transactions, (viii)
private placements, (ix) a de minimis number of
transactions, (x) safekeeping and custody services,
(xi) clearance and settlement activities, (xii)
securities lending, and (xiii) agency transactions
involving repurchase agreements. Exemptions from the
definition of "dealer" are provided for: banks that
engage in transactions involving (i) exempted and
similar securities, (ii) municipal securities, (iii)
bank and trust department transactions for investment
purposes, and (iv) (under limited circumstances)
certain categories of asset-backed securities. As
discussed in the testimony, the Commission is concerned
that these exemptions may create an incentive for
securities firms to transfer some of these activities
to a bank and away from Commission oversight.
-[38]- For example, the networking exclusion is consistent
with existing Commission policies -- although
incorporation of this exclusion into legislation would
deprive the Commission of flexibility it would
otherwise have to adapt the exclusion in response to
changing circumstances.
-------------------- BEGINNING OF PAGE #17 -------------------
would permit banks to conduct a significant volume of securities
business outside the regulatory framework established under the
federal securities laws. As a result, investors who buy
securities through their banks would continue to receive a
different standard of protection than other investors. In
addition, the Commission is concerned that, as securities firms
affiliate with banks, securities activities could "migrate" out
of securities firms and into affiliated banks, thereby weakening
the protections currently afforded investors.-[39]-
In addition to these general concerns, the Commission has
specific comments about the nature and scope of some of the
exemptions. Those comments are set forth in detail in the
appendix to this testimony.
To the extent that H.R. 18 seeks to allow banks to continue
engaging in traditional banking activities, it would be
preferable to rely on Commission exemptive authority (as provided
under Section 122 of the bill), rather than devising multiple
statutory exclusions for banks. At a minimum, the Commission
should be granted authority to impose additional safeguards or to
create specifically tailored exemptions in consultation with the
appropriate banking regulators to account for the continually
evolving financial markets.-[40]- The Commission also could use
such authority to adjust the exemptions to address any untoward
movement of securities activities out of broker-dealers and into
banks.-[41]-
-------- FOOTNOTES --------
-[39]- The Commission also notes that it will be difficult to
monitor and enforce the proposed exemptions. Although
H.R. 18 suggests that monitoring such exemptions is
appropriate, the tools to do so are not in place.
Specifically, the bill allows, but does not require,
bank regulators to obtain information from banks
regarding the banks' use of the exemptions. Notably,
the bill does not require a copy of such data to be
provided to the Commission. [See sec 103 of H.R. 18]
-[40]- Such authority would be similar to the authority H.R.
18 proposes to confer on the Federal Reserve, with
respect to modification of the statutory "firewalls"
provisions.
-[41]- Alternatively, in the event the exemptions are
retained, they should be revised (1) to prohibit the
general solicitation of the securities services
involved, and (2) to "expire" upon the affiliation of a
bank with a securities firm. These limitations would
be consistent with the assumption that underlies the
exemptions, i.e., the idea that banks have
traditionally provided securities services as an
"accommodation to customers," and should be allowed to
continue providing such traditional services so long as
they are not conducting a general securities business.
Notably, a prohibition against general solicitation is
already contained in H.R. 18's exemption for bank trust
activities, and a built-in "expiration" is included in
H.R. 18's exemptions for municipal securities,
affiliate transactions, private securities offerings,
(continued...)
-------------------- BEGINNING OF PAGE #18 -------------------
B. Bank investment advisory activities
H.R. 18 would amend the Investment Company Act and the
Advisers Act to address a number of issues raised when banks
manage and provide other services to registered investment
companies. Most importantly, the bill would amend the Advisers
Act to remove the exclusion for banks and bank holding companies
that provide investment advice to funds. As a result of this
amendment, a bank or a holding company that serves as an adviser
to a fund would be regulated in the same manner as any other
investment adviser to a fund. The Commission strongly supports
this change.-[42]-
H.R. 18 also would add provisions to the Investment Company
Act that are designed to address conflicts of interest and other
potential abuses that may exist when banks advise registered
investment companies. Because the Investment Company Act and the
Advisers Act did not contemplate that banks would be active
participants in the fund industry, the statutes do not
specifically address these conflicts of interest. The Commission
agrees that these statutes should be updated to reflect the
greater involvement of banks in the fund business. We believe,
however, that the Commission would be better able to address
conflicts of interest involving funds and banks if it were given
authority to define and deal with those conflicts by rule or
order. This authority would allow the Commission to strike a
balance between protecting investors from abusive conflict of
interest situations and enabling funds to engage in transactions
with affiliated banks that could be beneficial to shareholders.
This approach would also permit the Commission to avoid time-
consuming case-by-case applications for exemptions from outright
-------- FOOTNOTES --------
-[41]-(...continued)
and de minimis transactions. A built-in expiration
would prevent securities firms from transferring dealer
activities that are not traditional banking services,
such as dealing in structured notes, to the affiliated
bank and away from Commission oversight.
-[42]- The bill would allow banks to segregate their fund
investment advisory activities in a separately
identifiable department or division ("SID"), and to
register the SID (rather than the bank as a whole) as
an investment adviser. The primary benefits of
requiring banks and SIDs that advise investment
companies to register under the Advisers Act would be
the application of the following provisions: (1) the
regulation of performance fees under Section 205; (2)
the requirement under Section 204A to establish
procedures designed to prevent the misuse of non-
public information; and (3) the Section 206 anti-fraud
provisions, which are somewhat broader than the anti-
fraud standards under other applicable securities laws.
Registration would also improve the Commission's
ability to inspect bank-advised funds by requiring
banks and SIDs to provide the Commission with
additional information regarding the investment
management of these funds.
-------------------- BEGINNING OF PAGE #19 -------------------
prohibitions, which could become a drain on Commission
resources.-[43]-
Finally, H.R. 18 would address the issue of investor
confusion by prohibiting funds and their affiliated banks from
sharing common names.-[44]- The bill also would amend the
Investment Company Act to require disclosures by bank-affiliated
investment companies that securities issued by such companies are
not deposits, are not insured by the FDIC, and are not otherwise
obligations of the affiliated bank. In both these instances, the
Commission supports H.R. 18's goals.-[45]- Again, however, we
believe that a somewhat more flexible approach could be taken on
these matters; our detailed comments are set forth in the
attached appendix.
C. The problem of regulatory duplication and overlap
As described above, the Commission believes that H.R. 18
would make important progress toward a system of functional
regulation. However, the Commission believes that H.R. 18 could
go still farther than it does to reduce regulatory duplication.
In part, the Commission is concerned that some of the
-------- FOOTNOTES --------
-[43]- More detailed comments on some of the bill's specific
provisions are set forth in the appendix to this
testimony.
-[44]- This issue has long concerned the Commission. Two
years ago, the Commission staff advised investment
companies that the use of common names is presumptively
misleading. See Letter to Registrants from Barbara J.
Green, Deputy Director, SEC Division of Investment
Management (May 13, 1993). This letter noted that the
presumption could be rebutted through appropriate
disclosure. The letter requires bank-sold and bank-
advised funds to prominently disclose in their
prospectuses that fund shares are not deposits or
obligations of, or guaranteed or endorsed by, the bank
and that the shares are not federally insured by the
FDIC, the Federal Reserve Board, or any other agency.
-[45]- These provisions would respond to the issue (identified
in articles and studies) of customer confusion about
the uninsured status of bank-sold mutual funds. See,
e.g., SEC News Release 93-55, "Chairman Levitt
Announces Results of SEC's Mutual Fund Survey" (Nov.
10, 1993); "Banks' Fund Sales at Issue," New York
Times, March 9, 1994, at D2.
Recently, the NASD also took steps to address the customer
confusion issue. A pending NASD rule proposal would
establish requirements governing broker-dealers that sell
securities on bank premises. See NASD Notice to Members 94-
94 (December 1994). The proposed rule would, among other
things, specify where on bank premises a broker-dealer may
provide securities services; limit the activities and
compensation of unregistered personnel; require broker-
dealers to implement supervisory procedures; and mandate
specified disclosures to customers. This rule may be
revised before it is filed with the Commission for approval.
-------------------- BEGINNING OF PAGE #20 -------------------
inefficiencies and overlap inherent in today's regulatory
structure for bank securities activities would carry forward
under the bill.
To the extent that H.R. 18 would require banks to conduct
their securities activities in separate affiliates or
departments, subject to Commission regulation, the bill would
significantly improve the regulation of bank securities
activities today. Moreover, certain provisions in the bill would
facilitate coordination between bank and securities regulators in
a way that would promote functional regulation. For example,
Section 140 of H.R. 18 requires the appropriate agencies to
provide each other with examination reports or other information
related to the investment advisory activities of banks to the
extent necessary for each to carry out its respective statutory
responsibilities. This provision is intended to discourage
duplicative examinations of banks, conserve governmental
resources, and prevent inconsistent regulation of banks that
engage in investment advisory activities.
Other provisions of H.R. 18, however, appear to be
inconsistent with these goals, and would leave room for
continuing regulatory overlap and confusion. The Commission
understands that the banking agencies have a valid interest in
obtaining information about affiliates' operations to the extent
that such operations affect a bank's safety and soundness. But
proposed BHCA 10(f)(13)(D) suggests that the federal banking
agencies have a role to play in evaluating the compliance of
registered broker-dealers, investment advisers, and investment
companies with the federal securities laws. This is the
responsibility and function of the Commission, not of the banking
agencies. Similarly, proposed BHCA 10(f)(13)(H) suggests, by
negative implication, that the federal banking regulators may
conduct independent inspections or examinations of any investment
company affiliated with or advised by a bank. Such investment
companies, of course, are comprehensively regulated by the
Commission, and should not be subject to the possibility of dual
examinations.
The Commission believes that H.R. 18's enhanced information-
sharing and coordination provisions should be strengthened and
clarified. It would also be helpful if H.R. 18 modified existing
banking law to clarify and limit the extent to which the federal
banking agencies can impose bank regulation on registered
securities firms affiliated with banks.
D. Two-way street
As noted above, repeal of the Glass-Steagall Act would not
necessarily enable securities firms to acquire banks. In
response to this problem, H.R. 18 would give securities firms two
options.
First, a securities firm could become a bank holding company
by acquiring an insured bank. The bank holding company could
retain certain "financial" activities that would not be permitted
for bank holding companies generally. The barrier between
banking and commerce would be retained, however, and the
-------------------- BEGINNING OF PAGE #21 -------------------
securities firm would have to divest any nonfinancial business
within a maximum of ten years.
A second possibility for a securities firm would be to
acquire or spin off a wholesale bank and become a new "investment
bank holding company" ("IBHC") that could engage in activities
financial in nature and that would have access to the FedWire and
discount window.-[46]- As a result, securities firms (which
often have affiliates that engage in activities otherwise
impermissible under the Bank Holding Company Act) could become
IBHCs.
The Commission strongly supports efforts to promote a "two-
way street;" however, we have a number of concerns regarding how
these specific provisions would be implemented. As more fully
described above, securities firms, already subject to Commission
regulation, may be reluctant to submit to an additional overlay
of Federal Reserve oversight. It is not clear, therefore,
whether these options, as currently drafted, create a meaningful
opportunity for many securities firms.
In addition, the Commission is concerned that the IBHC
proposal may inadvertently create incentives for securities firms
to transfer some of their securities activities to a wholesale
financial institution and away from NASD and Commission
oversight. This could occur if an existing securities firm
decided to take advantage of some of the numerous new exemptions
for "traditional bank activities" in order to move securities
activities into the wholesale bank. For example, a securities
firm with a substantial government securities business could form
an IBHC and transfer its government securities business to the
bank in order to gain access to the Federal Reserve payments
system and discount window. Shifting such activities out of a
broker-dealer and into a bank would remove them from the well-
developed investor protection requirements contained in the
federal securities laws.
Notwithstanding these comments, the Commission believes that
H.R. 18's "two-way street" provisions do present securities firms
with options that they do not have today. In particular, the IBHC
vehicle, with the more limited form of bank-style regulation
contemplated, offers a good foundation for a continuing dialogue.
V. Conclusion
The Commission supports the goal of financial services
modernization, and believes that H.R. 18 represents a good first
step in that direction.
As the debate on Glass-Steagall reform goes forward, the
Commission urges Congress to go beyond bank safety and soundness,
-------- FOOTNOTES --------
-[46]- Such companies would be barred from controlling
"retail" banks (i.e., banks that accept insured
deposits); they could control only "wholesale financial
institutions," defined as uninsured state banks that
are regulated by the Federal Reserve.
-------------------- BEGINNING OF PAGE #22 -------------------
and also to consider the needs of investors and the markets. In
particular, the Commission urges Congress to keep these
principles in mind:
* Investor protection -- as well as bank safety and soundness
-- must be a priority.
* The vitality of the securities markets should not be
undermined by cumbersome or inequitable regulation.
The Commission looks forward to working with the Committee
on these issues.
======================== APPENDIX ===========================
This appendix supplements the general comments set forth in
the Commission's testimony of March 15, 1995; it contains
technical comments on specific provisions of H.R. 18.
A. Bank broker-dealer provisions
As noted in the March 15th testimony, the Commission has
both general and specific concerns about H.R. 18's thirteen
exemptions from the definition of "broker" and four exemptions
from the definition of "dealer." Our specific concerns include:
Private placements.
The exemption for bank private placement activities excepts
from functional regulation a traditional, and increasingly
significant, broker-dealer activity. One aspect of this
exemption would permit a bank (that has no securities affiliate)
to sell securities to persons with at least $200,000 in annual
income as part of a private placement, without being subject to
regulation as a securities broker-dealer. We question why an
important and growing area of securities activities should be
excluded from a functional regulation approach based on the
registration status of the securities in question: there is no
rationale for why private placement activity should not be
subject to Commission oversight merely because it is engaged in
by a bank, when all others engaging in identical activities are
be subject to Commission oversight.
De minimis exemption.
This exemption would permit a bank (that has no securities
subsidiary or affiliate) to effect up to 1,000 securities
transactions in a year -- 800 transactions in securities for
which a ready market exists, plus 200 transactions in any
security. Thus, a bank could advertise and actively market to
any investor, without securities regulation, some of the same
securities that have been subject to heightened Commission
scrutiny in recent years for sales practice abuses, such as penny
stocks and limited partnership interests.
Safekeeping, clearing, and related services.
-------------------- BEGINNING OF PAGE #23 -------------------
The Commission agrees that banks should not be considered
broker-dealers solely by virtue of acting in their traditional
and customary manner in providing safekeeping and custody
services, clearance and settlement transactions in securities,
securities lending, and collateral agency services. We
emphasize, however, that any exemptions along these lines should
be expressly limited to traditional and customary activities as
currently performed by U.S. banks. Otherwise, the exemptions
could create incentives for broker-dealers that currently engage
in such businesses to move these activities into an affiliated
bank and use them as an avenue to market their brokerage services
away from Commission oversight. Furthermore, all activity in
this area is not simply incidental to banking. Some banks, for
example, currently are marketing their brokerage services to
pension plans that have an existing relationship with their
custody services departments by offering commission rebates on
trades.
Government securities.
The Commission is particularly concerned by the exemption
for activities in government (including government sponsored
enterprise ("GSE") securities). The category of government
securities encompasses a broad spectrum of instruments, ranging
from Treasury bonds to GSE structured notes, such as the ones
purchased by Orange County. As demonstrated by Orange County's
recent investment in structured notes, investor protection
concerns arise even with the most sophisticated investors.-[1]-
The Commission recognizes that certain of these activities
have historically been conducted in banks. Nonetheless, we
believe that if a bank subsequently affiliates with a securities
firm, the bank's government securities activities should be
transferred to the securities firm.-[2]- The Commission is
concerned that H.R. 18's exemption for exempted securities is too
open-ended and creates an incentive to move government securities
activities out of securities firms and into bank subsidiaries to
gain access to the Federal Reserve Board payment system and
discount window, thereby generating substantial savings in
transaction costs. This would result in moving such activities
away from Commission and NASD oversight, into affiliated banks.
This would undercut the principle of functional regulation.
-------- FOOTNOTES --------
-[1]- See Testimony of Arthur Levitt, Chairman, Securities
and Exchange Commission, Before the Senate Committee on
Banking, Housing, and Urban Affairs (January 5, 1995).
-[2]- Banks already have an exemption for certain government
securities dealer activities. For example, banks whose
only government securities dealer activities are exempt
activities, including sales and subsequent repurchases
pursuant to a repurchase agreement, are exempt from
complying with many of the regulatory requirements of
Section 15C of the Securities Exchange Act of 1934.
The Commission believes that these types of activities
should continue to be conducted within the bank.
-------------------- BEGINNING OF PAGE #24 -------------------
Moreover, creating an incentive for securities firms to
transfer their government securities business to affiliated banks
would serve to undermine the goals of the Government Securities
Act Amendments of 1993 ("Amendments"). When Congress passed the
Amendments, it was aware that non-banks did the bulk of
government securities dealing.-[3]- In that context, Congress
determined that it was desirable to grant the NASD authority over
broker-dealers that are government securities dealers as a way of
establishing sales practice requirements for government
securities transactions analogous to those currently in effect
for registered broker-dealers generally.-[4]-
Solutions.
As noted in the text of today's testimony, to the extent
that H.R. 18 seeks to allow banks to continue engaging in
traditional banking activities, it would be preferable to rely on
Commission exemptive authority (as provided under Section 122 of
the bill), rather than devising multiple statutory exclusions for
banks. At a minimum, the Commission should be granted authority
to impose additional safeguards or to create specifically
tailored exemptions in consultation with the appropriate banking
regulators to account for the continually evolving financial
markets.-[5]- The Commission also could use such authority to
adjust the exemptions to address any untoward movement of
securities activities out of broker-dealers and into banks. The
other route -- building a large number of inflexible exceptions
into the statutory framework -- by contrast, is much more likely
to result, over time, in a large number of bank securities
-------- FOOTNOTES --------
-[3]- As of January 1995, 37 of the 38 primary dealers in
government securities were registered with, and
regulated by, the Commission. In addition, 2,156
registered broker-dealers dealt in government
securities as part of a broader business. Only 310
banks -- a significantly smaller number when compared
both with the number of registered broker-dealers that
are government securities dealers and the total number
of banks overall -- dealt in government securities.
The Office of the Comptroller of the Currency is the
primary regulator for the majority of banks (198) that
are bank government securities dealers.
-[4]- As a 1990 GAO report noted, "the absence of fair
dealing . . . makes transactions in government
securities by some individuals and smaller
institutional investors potentially vulnerable to
abusive dealer practices . . ." U.S. Government
Securities: More Transaction Information and Investor
Protection Measures Are Needed, GAO/GGD 90-114
(September 1990).
-[5]- Such authority would be similar to the authority H.R.
18 proposes to confer on the Federal Reserve, with
respect to modification of the statutory "firewalls"
provisions.
-------------------- BEGINNING OF PAGE #25 -------------------
activities being conducted outside of the broker-dealer
regulatory scheme.-[6]-
Alternatively, many of the exemptions (which are largely
derived from the concept that banks traditionally provided
securities services as an "accommodation to customers") could be
revised to prohibit the general solicitation of the securities
services involved. Such a prohibition is already contained in
the exemption for bank trust activities: H.R. 18 provides that a
bank will not be considered a "broker" by virtue of its trust
activities unless the bank publicly solicits brokerage business
(other than by advertising such services in conjunction with
other trust activities). Inclusion of a comparable prohibition
is particularly important with respect to the de minimis
exception, which we understand is only intended to permit smaller
banks to engage in accommodation transactions for their
customers.
Moreover, the Commission believes that most of the
exemptions, if maintained, should "expire" upon the affiliation
of a bank with a securities firm, after an appropriate transition
period designed to minimize any potential disruption to a bank's
business practice. Such an approach is already used in several
of the exemptions (e.g., the exemptions for municipal securities,
affiliate transactions, private securities offerings, and de
minimis transactions). In particular, this limitation should be
incorporated into the exemption for exempted securities,
including government securities. Otherwise, securities firms
will have an incentive to permanently transfer their government
dealing activities to the affiliated bank and away from
Commission oversight.
B. Margin requirements
H.R. 18 would amend the Exchange Act to eliminate outdated
restrictions on broker-dealer borrowing. Specifically, the bill
would remove the restrictions that prevent broker-dealers from
borrowing against securities to finance their normal business
operations.-[7]-
-------- FOOTNOTES --------
-[6]- In addition, the Commission notes that it will be
difficult to monitor and enforce the proposed
exemptions. Although H.R. 18 suggests that monitoring
such exemptions is appropriate, the tools to do so are
not in place. Specifically, the bill allows, but does
not require, bank regulators to obtain information from
banks regarding the banks' use of the exemptions.
Notably, the bill does not require a copy of such data
to be provided to the Commission.
-[7]- As currently written, Section 123 amends Sections 7(d)
and 8(a) of the Exchange Act to permit broker-dealers
to borrow from any person other than a broker-dealer to
finance their ordinary business operations (other than
to purchase securities for their own account).
Although we understand the intention of H.R. 18 is to
permit broker-dealers to borrow from any person for the
purpose of purchasing or carrying securities, Section
(continued...)
-------------------- BEGINNING OF PAGE #26 -------------------
H.R. 18 also would permit broker-dealers to borrow against
securities from any person that agrees to observe the rules of
the Federal Reserve Board. The evolving nature of our financial
markets, with greater reliance on non-bank sources of financing,
has made the current limitation to bank sources of financing on
securities unnecessary. We therefore believe H.R. 18 would
appropriately (1) loosen the restrictions on borrowing to finance
broker-dealer activities (including the purchase of securities
for customers), and (2) restrict borrowing against securities to
purchase for a broker-dealer's own account.
C. Bank investment advisory activities
The Commission supports H.R. 18's efforts to update the
Investment Company Act and the Advisers Act in light of growing
bank involvement in the investment company business. However,
because this involvement is a relatively new development, we
believe (as a general matter) that it would be advisable for many
of the investment company provisions to be modified somewhat to
give the Commission authority to deal with conflicts of interest
and other issues as they arise.
Customer confusion.
H.R. 18 is intended to address potential customer confusion
caused when investors purchase securities on bank premises or
purchase shares of a mutual fund that has a name similar to that
of a bank. We commend H.R. 18 for seeking to deal with this
issue, which has long concerned the Commission.-[8]-
First, the bill would amend the Investment Company Act to
prohibit a bank-affiliated investment company from adopting a
-------- FOOTNOTES --------
-[7]-(...continued)
7(d) of the Exchange Act governs the ability of persons
other than broker-dealers to extend credit for the
purchase or carrying of securities. Section 7(c),
which is not amended in the current draft, governs the
ability of broker-dealers to extend credit for the
purpose of purchasing or carrying securities. The bill
should amend Section 7(c) to clarify that broker-
dealers may extend credit to other broker-dealers for
use in the ordinary course of business (other than for
the purchase of securities for their own account).
-[8]- Because common names can be a source of customer
confusion, the Commission has advised investment
companies that the use of common names is presumptively
misleading. See Letter to Registrants from Barbara J.
Green, Deputy Director, SEC Division of Investment
Management (May 13, 1993). This letter noted that the
presumption could be rebutted through appropriate
disclosure. The letter requires bank-sold and bank-
advised funds to prominently disclose in their
prospectuses that fund shares are not deposits or
obligations of, or guaranteed or endorsed by, the bank
and that the shares are not federally insured by the
FDIC, the Federal Reserve Board, or any other agency.
-------------------- BEGINNING OF PAGE #27 -------------------
name that is the same as or similar to the name of its affiliated
bank.-[9]- The Commission believes that consideration should be
given to recasting this important provision to authorize the
Commission to adopt rules or issue orders to regulate this
practice. In particular, the Commission recommends that the
provision be revised to state that it is deceptive or misleading
for an investment company to use a name similar to that of an
affiliated bank in contravention of Commission rules or orders.
This approach would avoid an outright prohibition of common names
under all circumstances, and enable the Commission to respond to
particular names it concludes are potentially confusing to
investors.
Second, H.R. 18 would amend the Investment Company Act to
prohibit investment companies or sellers of investment company
securities from implying or representing that the company or any
security issued by the company is guaranteed by the U.S.
government, insured by the FDIC, or guaranteed by a bank. In
addition, the bill would mandate that the Commission adopt rules
to require that bank-affiliated investment companies and persons
selling bank-affiliated investment company securities
prominently disclose that the investment company or any security
issued by the company is not FDIC-insured and is not otherwise an
obligation of the affiliated bank. The Commission agrees that
such disclosure is necessary, but would recommend a more flexible
approach. In particular, we recommend that the provision be
revised to require bank-affiliated investment companies, and
persons who sell securities issued by such companies, to make
disclosures along the lines contemplated by H.R. 18 in accordance
with such rules as the Commission may prescribe.
Conflicts of interest.
Banks are now significant participants in the fund industry.
Because this was not the case when the Investment Company Act and
the Advisers Act were enacted, these statutes currently do not
address all of the conflicts of interest that may arise when
banks provide investment management and related services to
funds. H.R. 18 recognizes these conflicts, and addresses them by
prohibiting certain transactions between funds and their bank
affiliates. We believe that the Commission would be better able
to address such conflicts if it were given authority to define
and deal with those conflicts by rules or orders. This would
permit the Commission to strike a balance between protecting
investors from abusive conflict of interest situations and
enabling funds to enter into advantageous transactions. The
following paragraphs discuss the specific provisions of H.R. 18
relating to these conflicts of interest.
Fund acquisition of securities to satisfy bank customer's
indebtedness.
-------- FOOTNOTES --------
-[9]- Under the provision, the Commission would have the
authority to exempt an investment company from this
prohibition if it determines that an exemption is
consistent with the public interest and the protection
of investors.
-------------------- BEGINNING OF PAGE #28 -------------------
H.R. 18 would prohibit an investment company from knowingly
acquiring a security during the existence of an underwriting or
selling syndicate, if the proceeds would be used to retire any
part of an indebtedness owed to an affiliated person of the
investment company. This provision is intended to address the
possibility that a bank could use its affiliated fund as a source
of readily available capital to assist a financially troubled
borrower. The bank's indebtedness would be repaid, but the fund
could be left with unsuitable or risky assets. H.R. 18 would
prevent this scenario from occurring. We recommend, however,
that the bill be amended to provide the Commission with authority
to prohibit specific abusive situations of this type by rule or
order. The Commission is concerned that, because of the broad
wording of this provision, the bill could be read to preclude
securities acquisitions that would not be abusive.-[10]- The
recommended approach would allow regulatory flexibility and would
avoid prohibiting investment companies from participating in
appropriate and potentially advantageous securities transactions.
Borrowing from an affiliated bank.
H.R. 18 would prohibit a registered investment company from
borrowing money from an affiliated bank. This prohibition is
intended to deal with the potential for overreaching by a bank in
a loan transaction with an affiliated fund. H.R. 18 would
authorize the Commission to grant exemptions from this
prohibition. Under the Investment Company Act, mutual funds may
borrow only from banks. As discussed above, because the
Investment Company Act contemplates that banks would not have an
active role in the management of funds, the statute does not
specifically address potential overreaching when the lending bank
is affiliated with the fund. The Commission supports addressing
this issue legislatively, but we recommend that the bill be
amended to provide the Commission with authority to adopt rules
or issue orders that limit or prohibit banks from lending to
affiliated funds in those instances in which the potential for
overreaching exceeds the potential benefits to fund
shareholders.-[11]-
-------- FOOTNOTES --------
-[10]- For example, this provision could be read to prohibit
an equity fund from acquiring stock of an issuer whose
publicly traded debt securities happen to be in the
portfolio of an affiliated bond fund. Moreover, this
provision may increase the compliance responsibilities
of an investment company to monitor the securities
holdings and lending activities of all of its
affiliates. We question whether the interests of
investors will be furthered by imposing such an
extensive compliance burden on funds.
-[11]- Placing the restriction on banks would be consistent
with the affiliated transaction provisions of the
Investment Company Act, which prohibit affiliated
persons from engaging in transactions with a fund, but
do not make it unlawful for the fund itself to enter
into an affiliated transaction. Because a fund's day-
to-day operations typically are managed by its
(continued...)
-------------------- BEGINNING OF PAGE #29 -------------------
Bank serving as custodian for affiliated fund.
H.R. 18 would permit management investment companies to use
affiliated banks as custodians in accordance with Commission
rules.-[12]- While the Investment Company Act already gives the
Commission rulemaking authority regarding investment company
custodial arrangements, H.R. 18 would confirm that this
rulemaking authority extends to custodial arrangements involving
affiliated banks.-[13]- We support this provision.
Independence of board of directors.
H.R. 18 contains provisions that are intended to strengthen
the independence of a fund's board of directors. It would expand
the definition of "interested person" of an investment company to
include (1) any person who, within the past six months, executed
any portfolio transactions for, engaged in any principal
transactions with, or loaned money to the investment company, (2)
any person who, within the same period, has acted as custodian or
transfer agent for the investment company, and (3) any affiliate
of such persons.-[14]- H.R. 18 also would amend the provision
of the Investment Company Act that prohibits a majority of an
investment company's board of directors from consisting of
persons who are officers, directors, or employees of any one
bank. The bill would expand this restriction to cover officers,
-------- FOOTNOTES --------
-[11]-(...continued)
investment adviser, the adviser has the ability to
cause the fund to enter into affiliated transactions.
The affiliated transaction provisions recognize this
and place the burden of compliance on the adviser and
other affiliated persons rather than on the fund.
These provisions, therefore, empower the Commission to
pursue enforcement actions directly against those
persons that cause the fund to enter into affiliated
transactions.
-[12]- The bill would prohibit unit investment trusts ("UITs")
from using affiliated banks as custodians until the
Commission permits such arrangements by rule. There
appears to be no reason to distinguish between the
custodianship of UIT assets and that of other
investment company assets and, therefore, we recommend
that this provision be modified to permit UITs to use
affiliated bank custodians in accordance with
Commission rules.
-[13]- While the rule governing investment company self-
custody of assets has been applied to cover custodial
arrangements with affiliated banks, we believe the
Investment Company Act should be amended to indicate
more clearly the Commission's authority to adopt rules
relating to affiliated bank custodianships.
-[14]- We question the need to include custodians, transfer
agents, and their affiliates as interested persons. It
would appear that the conflict of interest potential
raised by a board member's being affiliated with a
custodian or transfer agent is rather minimal.
-------------------- BEGINNING OF PAGE #30 -------------------
directors, or employees of any single bank holding company
(including its subsidiaries and affiliates) or of any single bank
(including its subsidiaries). We support this provision.
Voting requirements when bank holds controlling interest in
fund as a fiduciary.
Next, H.R. 18 would address certain conflicts that may arise
when a bank that advises a fund also holds a controlling interest
in the fund in a fiduciary capacity.-[15]- To ensure that the
bank does not use its fiduciary authority to further its own
interests (such as voting to perpetuate itself or its affiliate
as investment adviser to the fund), H.R. 18 would require the
fiduciary to follow certain procedures when voting fund
shares.-[16]- The voting requirements would not apply to banks
holding investment company shares on behalf of common trust
funds, pension plans, governmental plans, and collective trust
funds. We support this provision with minor technical changes to
clarify these exceptions.
Acquiring investment company shares as a fiduciary.
Finally, H.R. 18 would add a new provision to the Investment
Company Act to impose a disclosure requirement on a fund's
investment adviser when the adviser purchases the fund's
securities in a fiduciary capacity. The adviser would be
required to provide disclosures as prescribed by the Commission
to the person to whom periodic financial statements of the
fiduciary account are sent (typically the person who created the
trust). This provision authorizes the Commission to adopt rules
to protect fund investors who are also trust beneficiaries, and,
at the same time, authorizes the appropriate banking agency to
review purchases by fiduciaries of securities issued by
affiliated investment companies. Although the Commission
acknowledges the potential conflict of interest that arises when
a fund's adviser purchases shares of the fund in a fiduciary
capacity, the Commission questions whether the Investment Company
Act is the appropriate statute to deal with that conflict of
interest. Such a conflict would appear to involve not the
operations of an investment company, which are governed by the
Investment Company Act, but the relationship between the bank as
fiduciary and its clients or customers. The Commission submits
that issues involving that relationship would be better addressed
by amending the federal banking laws or the rules adopted under
those laws than by amending the Investment Company Act.
Common trust funds.
-------- FOOTNOTES --------
-[15]- Section 2(a)(9) of the Investment Company Act (15
U.S.C. 80a-2(a)(9)) creates a presumption of "control"
where a person owns more than 25% of a company's voting
securities.
-[16]- Specifically, H.R. 18 would require the fiduciary to
(1) pass through voting rights to beneficiaries or
certain other designated persons, (2) vote the shares
it holds in proportion to all other shareholders, or
(3) vote in accordance with Commission rules.
-------------------- BEGINNING OF PAGE #31 -------------------
H.R. 18 would codify a long-standing Commission position
that the exception from the securities laws available to bank
common trust funds-[17]- applies only if the fund is used solely
to accommodate bona fide pre-existing trust clients of a bank,
and is not advertised or offered to the general public.-[18]-
The bill would modify the language of the common trust fund
exception in the Investment Company Act, and the companion
provisions in the Securities Act and the Exchange Act, to
restrict the exception's applicability to a common trust fund
meeting three conditions. First, the common trust fund must be
employed solely as an administrative convenience for the
management of accounts created and maintained for fiduciary
purposes. Second, interests in the fund may not be advertised or
offered for sale to the public, except in connection with generic
advertising of the bank's overall fiduciary services. Third, the
common trust fund may not be charged any fees or expenses that,
when added to any other fee charged to a participant account,
would exceed the total compensation that would have been charged
if no assets of the participating account had been invested in
the common trust fund, except for "reasonable and necessary
expenses related to the prudent operation of the fund," as
determined by the appropriate federal banking agency. We support
this provision.
-------- FOOTNOTES --------
-[17]- The federal securities laws exempt interests in common
trust funds from the registration requirements of the
Securities Act of 1933 (15 U.S.C 77c(a)(2)) and
exclude common trust funds from the definition of
investment company under the Investment Company Act (15
U.S.C. 80a-3(c)(3)). In addition, because interests
in common trust funds are exempted securities under the
Securities Exchange Act of 1934 (15 U.S.C.
78c(a)(12)(iii), persons effecting transactions in
these interests need not register as broker-dealers.
The definition in each of these statutes is virtually
identical, limiting the exception to any common trust
fund or similar fund maintained by a bank exclusively
for the collective investment or reinvestment of moneys
contributed thereto by the bank in its capacity as a
trustee, executor, administrator, or guardian.
-[18]- E.g., In the Matter of The Commercial Bank and Marvin
C. Abeene, Admin. Proc. File No. 30-8567 (Dec. 6,
1994). See also Investment Company Act Rel. No. 3648
(Mar. 11, 1963); H.R. Rep. No. 429, 88th Cong., 1st
Sess. 11 (1963).
END OF DOCUMENT